Thank You

Error.

Municipal bonds just got a last-minute reprieve from Congress -- and some added appeal for 2013.

Gary Hovland for Barron's

A year-end deal to raise tax revenue left a century-old tax perk for munis intact. The deal also increased taxes on high earners, making munis more attractive. Income earned on most munis is free from federal tax, as well as state and city tax for investors who buy local. That allows muni issuers -- state and local governments and their agencies -- to raise financing at low rates. The more an investor pays in taxes, the higher the yields on taxable bonds must be to beat the tax-free yield from munis.

At the moment, 10-year munis rated single-A ("low credit risk") by Moody's yield 2.6%, versus 2.8% for comparable corporate bonds. That makes munis as good a deal as corporates, even for an investor who pays 10% in taxes -- and a better deal for the many investors who pay more.

High earners will pay more this year than last. The recent deal in Congress raises the top tax bracket to 39.6% from 35% for individuals who make more than $400,000 and couples who earn more than $450,000. There's also a new 3.8% health-care tax on investment income for individuals who make more than $200,000 and couples who make more than $250,000.

Those changes give muni yields added appeal that's the equivalent of yields suddenly jumping by four-tenths of a percentage point, says Dan Heckman, a fixed-income strategist at U.S. Bank Wealth Management. "Investors haven't quite priced the higher taxes into the market yet, so we expect munis to do well in 2013," he says.

The Bottom Line

With their tax-exempt status preserved, muni bonds look good. But investors should avoid the highest yielders, such as those issued by Puerto Rico.

Don't count on a repeat of 2012, when the S&P Municipal Bond Index returned 7.4%. More than half of that came from price gains, as falling yields on Treasury bonds drove investors to alternatives. Treasury yields recently rebounded off historic lows, suggesting that opportunities for price gains in 2013 are smaller. Expect total returns for munis of 2% to 3% -- yields plus a smidgen in gains, says Steve Wlodarski, a portfolio manager at McDonnell Investment Management, which oversees $13.5 billion. Historically, yields on munis have been equal to about 85% of those on equivalent Treasuries, but today they're around 100%, which bodes well, he says.

Mutual funds are the best route for investors putting less than $500,000 in munis (and a good route for those putting more), because they offer plenty of diversification and liquidity and, some of them, low fees. With starting yields of about 2% for many funds, any fees exceeding 0.5% a year deserve heavy scrutiny; ones below 0.25% are best. Upfront sales charges are out of the question.

For a core holding, look to
Vanguard Intermediate-Term Tax-Exempt
(ticker: VWITX). It avoids leverage, costs a slim 0.2% of assets per year, has an average credit quality of single-A, and keeps the average bond duration short, about five years. The longer a fund's average duration, the more sensitive it is to changes in interest rates. So with rates this low, limited duration is a plus.

Three Takes on Muni Funds

Plain-vanilla muni funds are still a good bet for most investors, but you can get a little extra yield without taking on too much extra risk.

Expense

1-Yr

Fund Name/Ticker

Yield

Ratio

Return

Vanguard Int. Term Tax Exempt /VWITX

1.6%

0.20%

5.3%

TRP Summit Municipal/PRINX

2.5

0.50

9.3

TRP Tax-Free High Yield/PRFHX

3.3

0.68

13.1

Note: Returns as of 1/10/13 Source: Morningstar

There's another advantage of sticking with intermediate maturities: "roll-downs." Short-term bonds are in fierce demand now, which keeps their prices high and their yields low. An investor who buys intermediates and waits for them to become shorter-term issues should see some price appreciation along the way, provided rates stay where they are. It's no guarantee of gains, but investors who position themselves for roll-downs stack the odds in their favor. The Vanguard fund has returned an average of 4.8% a year over the past 15 years, ranking among the top 26% of muni funds, despite its limited risk, according to Morningstar. It yields 1.6%.

For a more daring (but not reckless) approach, Todd Rosenbluth, director of fund research at S&P Capital IQ, recommends
T. Rowe Price Summit Municipal Income
(PRINX). Its average bond duration is a touch longer (six years), and its credit quality lower (triple-B), but its yield is considerably higher, at 2.5%. And its managers have gotten excellent results, with a group-leading average annual return of 5.4% over the past 15 years. Expenses are 0.5% a year.

There are even higher yields to be found, of course, but use caution. Many of them involve the use of leverage or "junk" bonds, those rated below investment grade. Both add risk. Junk bonds aren't necessarily bad. Another T. Rowe fund,
T. Rowe Price Tax-Free High Yield
(PRFHX), has flourished by sticking just a foot into the junk pool. About 70% of the portfolio is rated investment grade. The fund yields an ample 3.3%, and it has returned an average of 5% a year over the past 15 years, ranking among the top 18% of high-yield muni funds. As is typical for funds that delve into junk, the fees are higher -- 0.68% of assets per year.

However, one problem with buying junk munis is that the spread between their yields and those on high-quality munis has shrunk in recent months, meaning that investors are no longer being rewarded as handsomely for the extra risk. Another problem, says U.S. Bank's Heckman, is what's happening in Puerto Rico, a U.S. commonwealth whose bond income is exempt from federal and state taxes for most U.S. investors. Big pension and budget shortfalls there led Moody's to slash the island's bond rating last month to just above junk status; Puerto Rican bond prices have plunged. Without big changes, Puerto Rico could be headed for default within a few years, says Heckman. If that happens, the ripple effect could cause investors to sour on bonds of lower credit quality elsewhere in the U.S.